Beware of ETFs that promise to beat the market

Opinion: Take a passive view of actively run ETFs

By

JohnPrestbo

More and more fund companies are filing with the Securities and Exchange Commission to offer actively managed ETFs, which are predicted to become a major growth driver for the asset management business.

This makes sense for the fund companies. They want to gather as many assets as possible from as many investors as possible and charge what the traffic will bear to manage the money. And investors still seem willing to pay up for active management while becoming increasingly price-sensitive on index-based ETFs.

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Would you buy a stock that even the salesman thinks is going to go down? Probably not, but that’s exactly what investors are being sold on for a number of stocks, Barron’s Jack Hough says on MoneyBeat.

How this development makes sense for investors is beyond me, however. Actively managed funds promise to “beat the market,” but studies repeatedly show that they usually don’t — especially after fees are deducted. The ones that occasionally succeed rarely persist in outperforming. What’s to like in this picture?

Power and influence are among the answers. The fund companies are rushing to set up actively managed ETFs partly because they sense that institutional investors are starting to love these vehicles in a big way. According to etf.com, only about 18% of institutional investors currently hold ETFs, suggesting plenty of potential growth.

Institutions are long used to dealing with active managers. Several of these big investors have made news by allocating some of their portfolios to indexed investments, but by and large they are familiar and comfortable with active management.

Now consider: Many institutional investors are run by people, often on committees, who are exposed to political influences or are politicians themselves. In this realm, “beating the market” could mean, say, smaller funding contributions to pension plans and therefore more tax money to spend on things favored by voters.

This point is not being ignored by the fund companies competing fiercely to snag the big chunks of capital that institutions have. They also are educating institutional investing staffs on the flexible ease of trading ETFs compared to the contractual red tape often involved with parking big money in mutual funds or with money management firms.

Wining, dining and destination-resort “conferences” are still part of the lobbying game, to be sure. But institutions are increasingly attracted to the benefits of the ETF vehicle itself. They don’t care as much about rock-bottom fees or underlying indexes. They care more about finding the right flavors of strategy in ETF format, and the fund companies are positioning themselves to offer it.

Trades and poor trade-offs

The first thing the fund companies would like to eliminate from active ETFs is transparency. At present, all ETFs must disclose their holdings daily, but fund companies have petitioned the SEC to permit active-ETF disclosure far less frequently. The rationale is that daily transparency allows competitors to front-run an active fund’s strategy.

True enough, but if the regulators go along individuals will be stuck with pig-in-a-poke choices that ETFs freed them of. Individual investors won’t know if the active fund is diversifying their portfolios or doubling down on the risks. Can you imagine institutional investors being willing to expose their assets to this potluck treatment? Don’t worry, their information needs will not go unnoticed.

More important, though, is that the ETF vehicle doesn’t alter the odds in active vs. passive investing: Over time, most stock-pickers underperform market benchmarks. Higher fees are one reason, but so is the fact that investing strategies go in and out of favor with Mr. Market. The indexed investor accepts steadier market returns over occasional and unpredictable home runs by a stock picker.

Vanguard is one of the fund companies that has applied for active ETFs, though it says it isn’t entirely sure it will offer them. Among its actively managed mutual funds mentioned as a possibility in ETF form is Vanguard Explorer
VEXPX, +0.45%
specializing in small-cap growth stocks. It charges annual expenses of 0.50% and has $5.4 billion in assets.

Its comparable exchange-listed fund is the Vanguard Small-Cap Growth ETF
VBK, +0.47%
Its expense ratio is 0.10% and it has $15.2 billion in assets. As of last year it replicates the CRSP US Small-Cap Growth Index, which has a median market cap for components of $3.1 billion. (Previously it tracked two other small-cap growth indexes.) Vanguard Explorer, by contrast, has a median market cap of $4.3 billion.

The following table shows cumulative NAV performance for the two portfolios over the decade ended March 3:

1 Year

3 Years

5 Years

10 Years

VEXPX

31.89%

49.14%

178.81%

149.53%

VBK

30.07%

47.52%

194.57%

184.54%

The mutual fund wins in the one- and three-year periods, but the ETF does much better over longer stretches. While the two funds are working the same market segment, more or less, they obviously are taking different approaches.

In this case, there is room for an active ETF version of the mutual fund. But it doesn’t suggest that an indexed investor abandon ship and “go active.” As more active ETFs hit the market, individual investors would do well to heed the wisdom of this adage: Just because you can do something doesn’t mean you should.

John Prestbo is retired as editor and executive director of Dow Jones Indexes, now part of S&P Dow Jones Indices, in which Dow Jones & Co., publisher of MarketWatch, holds a small interest. Prestbo also is an adviser to MarketGrader Capital, which scores stocks on the basis of fundamental factors and chooses components of the Barron’s 400 Index

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